Ultimate goal: value creation in M&A

August 2022  |  COVER STORY | MERGERS & ACQUISITIONS

Financier Worldwide Magazine

August 2022 Issue

Creating value is the ultimate goal of any M&A transaction, a bona fide way of boosting top-line growth and shareholder return. The reality, however, is that value creation is often a challenging endeavour, with many deals resulting in disappointing financial numbers and synergies, and acquirers losing money.

According to the PwC and Mergermarket study ‘Creating Value Beyond the Deal’, more than 70 percent of mergers fail to deliver anticipated shareholder value. In many cases, integration ends up costing more and takes longer than planned, with anticipated upsides proving challenging to realise, and acquirers becoming exhausted and disengaged.

Moreover, the study states that 53 percent of acquirers are underperforming their industry peers, on average, over the 24 months following completion of their last deal based on total shareholder return (TSR). Similarly, 57 percent of divestors are underperforming their industry peers, on average, over the 24 months following completion of their last deal based on TSR.

In its analysis of value creation in M&A, the Boston Consulting Group (BCG) found that a recipe for unrealised value was an attitude among acquirers that value-creating activities can be tacked onto their existing day-to-day business responsibilities. However, this generally proves to be wishful thinking, with the result that, while transactions still went through, they never unlocked their full potential.

“That companies are highly susceptible to destroying shareholder value through M&A is among the most well-documented of empirical observations,” says Jenny Zhenyi Huang, lecturer in finance and accounting at University College London (UCL). “Although the success of an M&A deal is ultimately contingent on the synergistic gain attained by the combination of two companies, it has been argued that inadequate post-merger integration is responsible for a large part of the value erosion observed in M&A deals.”

Despite reams of research and empirical evidence indicating that many transactions fail to realise the value that they intended, on the flip side, deals that are executed well and that prioritise value creation have a greater chance of generating significant synergies.

Synergies

So, what are the baseline factors for creating synergies and value in deals? In its analysis of value creation and synergies, McKinsey recommends that dealmakers establish a framework, outlined below, for identifying, quantifying and capturing synergies that defines the three layers of value creation.

First, protect the base business. McKinsey found that acquirers typically see sales decline eight percent in the quarter after announcing a deal. Companies can avoid this pitfall by: (i) maintaining accountability for current-year results and making investments to sustain quality; (ii) separating integration efforts from running the business; (iii) shortening the post-announcement, pre-close period and announcing the new management team as early as possible; and (vi) retaining customers and important talent through shared aspirations, clear communication and appropriate incentives.

Often, however, a company’s zeal to achieve due diligence targets often makes it myopic. It overinvests executive attention and integration talent in that effort, failing to protect the base business or organise clean teams that could scope the full landscape of value creation opportunities so the combined company could begin to profit on day one.

Second, capture combinational synergies. The majority of efforts to capture combinational synergies focus, at least initially, on cost and capital. These efforts typically exceed ‘expected’ short-term estimates. However, because they rely on across-the-board rules of thumb and ratios, they often underestimate savings, leaving money on the table. Boiled down, a company that is focused only on cost and capital is overlooking growth opportunities represented by revenue synergies.

Furthermore, studies have shown that a failure to consider revenue synergies from the start of the M&A process may delay realisation of any value by a year or more. To avoid this pitfall, companies can organise cross-functional teams to define ways to meet synergy targets and develop realistic plans for achieving targets.

Lastly, seek select transformational opportunities. Transformational synergies represent huge potential for breakthrough performance. That said, transformation involves complexity that often exceeds management’s capacity and can bring the business to a grinding halt. Management needs to focus selectively – on a handful of targeted functions, processes, capabilities or business units that make breakthrough performance possible and financially worthwhile.

Needless to say, the factors driving synergy value apply to any deal, whatever its size. “If we take a look at one of the largest value-destruction cases in history, the $99bn write-off of AOL Time Warner, strategic assumptions were not valid, the merged firm did not have the capabilities to explore new opportunities, and cultures were never successfully integrated,” notes Scott Newton, managing partner at Thinking Dimensions. “After acquiring AOL for $165bn in 2001, the business unit was sold off to Verizon in 2015 for only $4.4bn.”

Mindset

With synergies identified and quantified, it is of paramount importance for acquirers to have a value-creation mindset in place. That mindset should be hardwired across the M&A lifecycle and go beyond what is expected to explore untapped areas of growth.

“A value-creation mindset is critically important,” suggests Mr Newton. “Successful acquirers have already built their first case for value creation before even drafting a letter of intent (LOI) or term sheet. The most challenging hurdle in value creation is to think about the business from the customer point of view. In many organisations, boards and management tend to be very internally focused.

“This challenge, for example, led to the board of Blockbuster declining to invest in Netflix at seed level terms,” he continues. “Ideally, acquirers should be able to describe the optimal state of the transaction in the future. What will it look like? How will we get there? What are the breakthroughs that will deliver exceptional returns to investors?”

Providing at least some of the answers to these questions is the PwC/Mergermarket study which outlines the approach dealmakers should be taking early on in the buying and selling process, as described below.

First, stay true to the strategic intent. Organisations should approach deals as part of a clear strategic vision and align deal activity to the long-term objectives for the business. Eighty-six percent of buyers surveyed in the study who stated that their latest acquisition created significant value, also said it was part of a broader portfolio review rather than opportunistic.

Second, be clear on all the elements of a comprehensive value-creation plan. Ensure a thorough and effective process for conducting the deal with the necessary diligence and rigour in the value creation planning process across all areas of the business. Consider how this supports the business model, synergy delivery, operating model and technology plans. For acquisitions with significant value lost relative to purchase price, 79 percent did not have an integration strategy in place at signing, 70 percent did not have a synergy plan in place at signing, and 63 percent did not have a technology plan in place at signing.

Finally, put culture at the heart of the deal. Talent management and human capital affect how businesses are able to deliver value pre- and post-deal. Eighty-two percent of companies that say significant value was destroyed in their latest acquisition lost more than 10 percent of their employees following the completion of the transaction.

“It is essential to have the mindset of value creation throughout the deal planning and execution process,” contends Dr Huang. “However, though synergy value is often expected at the time of the deal announcement, it is rarely delivered in the post-deal stage, largely due to the complexities and difficulties in the integration of the two businesses.”

Challenges

While M&A, theoretically at least, presents significant opportunities, it also provides complex challenges for achieving synergy and creating value. Integration teams and senior leadership need to carefully address those challenges.

“The valuation of an M&A deal is a complex notion which involves consideration of multiple dimensions of company and deal characteristics, such as the firm’s corporate governance quality, ownership structure, firm size and deal payment method, among others,” affirms Dr Huang. “Furthermore, the complexity of valuation can be even higher for cross-border transactions and deals involving firms from very different industries.”

To help increase the likelihood of deal success, Dr Huang believes it is crucial for the acquirer to establish a dedicated in-house team with leadership having prior M&A deal experience that can collaborate effectively with external financial and legal advisers for optimal deal execution. “Given the complex nature of the post-deal integration, especially with significant challenges arising from cultural disparity, it is highly important to have a designated integration team to work through differences between the companies, such that the optimal operation can be coherently shaped for the combined business,” she adds.

In terms of transformation cases, Mr Newton notes that boards, investment committees and financial managers often have difficulties in valuing the opportunities of tomorrow. “The majority of teams are very comfortable with earnings before interest, taxes, depreciation and amortisation, free cash flow and book values,” he observes. “However, they struggle to evaluate new disruptive technologies which may not yet be profitable, or clearly understand how industry shifts will disrupt their current business models.

Measuring value creation

According to most studies, it generally takes 12 months after an M&A deal is completed to determine the success of the transaction, with the measures of success including the company’s share price, accounting measures such as sales, profits, return on assets, return on investments or senior managers’ subjective assessments of performance.

In the experience of Ramkumar Raja Chidambaram, head of corporate development at Tata Elxsi, a buyer needs to perform the following activities to measure value creation. First, identify critical operating and value drivers of the target business. Second, value the target business without synergies and control. Third, value synergies by computing cost and tax savings, additional revenues and improving the target firm’s operating performance. Finally, decide the maximum price the buyer can pay for the deal and back out if the seller demands a higher price.

Appetite for value

Although the appetite for M&A is likely to remain strong in 2022 and beyond, the chances are that value will continue to be left on the table, frequently without dealmakers even realising it. This is an unsatisfactory scenario that arises when value creation plans are viewed as a tick the box item to get the deal over the line.

In the view of Mr Chidambaram, companies looking to grow through M&A in 2022 should undertake the following. First, consistently engage in M&A deals that are strategically relevant and improve their market cap. A buyer that closes two to three small or medium-sized deals annually has a better success rate than companies that engage in M&A sporadically.

Second, remember that M&A is a significant lever for accelerating growth. If the seller demands a higher premium resulting in higher deal valuations, or the deal is risky, the buyer should explore joint ventures, business alliances and partnerships to improve growth.

Finally, integration is crucial and must work flawlessly from day one through to the final integration of the asset. The buyer should understand the sources of synergies and cost savings, execute synergies and make operating improvements by sticking to the fundamentals, and identify the right target firms that can add to the buyer’s shareholder value, and not overpay.

“The coronavirus (COVID-19) pandemic and the rising cost of living have driven inflation, which, in turn, is expected to lead to a rise in interest rates in the years ahead,” foresees Dr Huang. “Since a lot of M&A deals are financed with debt, many acquirers will be desperately pushing to complete deals before funding becomes more expensive.

“This urgency could compromise an acquirer’s deal planning and price negotiation, and as a result, erode M&A value creation,” she continues. “In addition, the increased protectionism at a political and local level may affect deals between different markets, which can result in additional costs for cross-border deals and thus puts pressure on value creation.”

In conclusion, value creation should be a priority during M&A deal processing and lead companies to maximise value creation to achieve maximum synergies. What is more, with companies under increasing pressure to deliver more value from their M&A activities, those that establish rigorous criteria for value creation early in the buying process are the ones best positioned to maximise returns from a transaction.

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Fraser Tennant